SEC Examines Secondary Market Trading

A healthy trading market has emerged around the shares of some well-known private social networking companies--Facebook, Twitter, LinkedIn (which has since filed for an IPO) and Zynga, the creator of online games such as FarmVille. This secondary market is allowing investors to easily trade the shares of private companies, a development that has provided a simple funding and investing opportunity for private companies and their would-be investors.

It's also gained the scrutiny of the Securities and Exchange Commission (SEC). In December 2010, the New York Times reported the SEC had sent information requests to unnamed participants in the secondary market for trading shares of the four aforementioned social networking companies. The commission also is taking a look at the exchanges themselves, which act as neutral links between buyers and sellers. It has remained silent on the investigations, but observers speculate that a main point of focus for the agency may be Section 12(g)(1) of the Exchange Act, which imposes the reporting requirements of a public company on companies with more than 500 shareholders of record.

Shareholder Limit

The limit reportedly was the impetus behind Facebook's January announcement of its intentions to go public by April 30, 2012. The company expects to exceed 500 shareholders this year and would have to comply with SEC disclosure rules 120 days after the end of FY 2011.

It's likely that the SEC wants to ensure that private companies aren't taking advantage of these markets or related investment vehicles to stay below the 500-shareholder milestone and sidestep such financial disclosure rules and, more generally, to ensure fair trading activity in a rapidly emerging market.

"Historically, the SEC's mission has focused on protecting investors by making sure there is adequate information available about companies and their shares, and not by precluding investors from making risky investments," says Laurence Weiss, a partner at Hogan Lovells.

Missing Link

Private equity exchanges have become prominent over the past two years, allowing easy trades of private stock that previously was largely illiquid.

SecondMarket, the most well-known of these exchanges, said in January that the completed transactions on its system reached $157.8 million in the fourth quarter of 2010, more than doubling the amount traded the previous quarter. Thirty-nine percent of SecondMarket's trades were Facebook stock.

"There's no interest in the shares of the vast majority of private companies, but when you start talking about huge private companies that have a lot of public interest and are hot right now, like Facebook and Twitter, then there's a lot of interest in trading those shares--both from people who own them and people who are interested in making an investment," says Bryan Clark, managing partner at Cane Clark.

Such exchanges are making it possible for companies, if they generate enough cash through their operations, to gain access to capital without the onerous time and cost demands of going public and facing Sarbanes-Oxley reporting requirements. Vincent Molinari says it's largely because of the development of a new marketplace that Facebook's valuation rose to $50 billion in January 2011 from $14 billion just a year earlier.

"I couldn't imagine too long ago a private company accelerating in value like that without having some sort of public listing," says Molinari, CEO of Gate Technologies, which creates electronic trading platforms that enable such trades. "It's a growing trend, and it runs from the largest private companies like Facebook right down to smaller private companies, doing much smaller rounds of funding, that could access capital in the same way."

Growing Uncertainty

Clark describes the exchanges as similar to e-bulletin boards: They bring together buyers and sellers, provide a common set of neutral contracts and arrange for banks to escrow cash. They don't actually process the trades in the way a typical exchange would, and they don't make money on the actual transaction.

The exchanges serve as a marketplace for investors who otherwise would have to do an individual face-to-face transaction to sell nonpublicly traded, nonregistered stock--which leads back to the 500-shareholder limit and the SEC inquiry.

"What seems to be happening with these services is they accelerate the move to more than 500 shareholders," Clark says. "These exchanges are exacerbating the natural problem--if you have 100 shares and give them to 10 people, and they register the shares with the company, now that's 10 shareholders of record."

And when an employee or early investor visits an exchange to sell their shares, one buyer could be more than one person--a group may have created a special purpose investment vehicle (SPV) that acts as one holder on the record with possibly hundreds behind the scenes. SecondMarket declined comment on this story, but it said in a prepared statement that it had received a request for information from the SEC regarding "pre-IPO pooled investment funds" and was cooperating with the agency.

One question is how the SEC could interpret the motives behind the pooled funds. Section 12(g) provides that each SPV participant would be deemed an owner of record if "the form of holding securities of record is used primarily to circumvent the provisions of Section 12(g)."

The uncertainty would have affected the SPV Goldman Sachs created to sell shares in Facebook--reportedly, hundreds of investors were interested. Goldman Sachs bypassed the issue by announcing it would only offer the shares overseas, a decision that came after the SEC's inquiries became public knowledge. Goldman said it made the decision following the rampant media coverage of its creation of the Facebook SPV, which the SEC could view as solicitation.

It wouldn't be surprising, however, if another issue at play in Goldman's decision was uncertainty over the 500-shareholder limit in the face of the announced SPV.

According to Molinari, that uncertainty in SEC interpretation is creating huge problems for companies. Depending on SEC interpretion, they could face the prospect of investigation, enforcement actions and private litigation. "All of a sudden, companies are faced with the issue that they thought there were fewer than 500 shareholders, but now overnight they're deemed 500-plus and have to be in a public position in 120 days [from the end of the fiscal year]," he says.

In the meantime, eyes remain on the Facebooks of the world and the exchanges driving their stratospheric rise.